Small Business Tax Questions: Are You Required To Pay Employment Taxes?

December 18, 2011 by  Filed under: Taxes 

If you own a small business, do you have to pay employment taxes on compensation paid to your workers? Read on to find out.

The short answer to this question is, of course, “it depends”. It depends on whether your workers are employees or independent contractors. Here’s the general rule: if you hire employees, you must withhold and/or pay employment taxes on wages, salaries, commissions, bonuses and any other form of compensation for services rendered. And if you hire independent contractors, you are not required to withhold or pay employment taxes on non-employee compensation.

Let’s discuss the requirements for employees first. By “employment taxes”, I’m referring to the following: federal, state and local income taxes; Social Security taxes; Medicare taxes; federal unemployment taxes; state unemployment taxes; other forms of state and local payroll-related withholdings, such as disability insurance or employment training taxes.

These various taxes are also known as “payroll taxes”. Some of them are withheld from the employee’s paycheck and so, in effect, are paid only by the employee (such as income tax withholdings). Other payroll taxes are paid only by the employer (such as federal and state unemployment taxes). And there are also taxes that are paid by both employee and employer (Social Security and Medicare taxes).

The end result is that for a small business with just one employee (which could be you), payroll taxes must be calculated, withheld and paid according to the appropriate payment schedules of federal, state and local taxing authorities. If you fail to withhold and/or pay these taxes, you will likely face stiff penalties and interest.

In addition to making payroll tax payments, the employer must also file payroll tax returns and information returns. The federal tax returns include Form 940 and Form 941. The federal information returns include Form W-2 and Form W-3. Each state will also have its own unique payroll tax return and information return filing requirements.

In contrast, paying independent contractors results in a much less complex situation. You are required to file annual information returns known as Form 1099-MISC and Form 1096 for any contractors to whom you paid $600 or more during the year. And that’s about it. There are no payroll tax payments and there are no payroll tax returns.

Obviously, the difference in government compliance between employees and independent contractors is huge. It’s no secret that it costs significantly less to hire a contractor than an employee. But the law does not allow you to decide how to treat your workers based on the cost. Other factors determine the correct classification of your personnel, so be sure to research this thoroughly and consult with a tax professional to insure you do this right.

Looking for more small business tax deductions? For a free copy of the Special Report “How to Instantly Double Your Small Business Tax Deductions” visit Wayne Davies is author of 3 ebooks on tax reduction strategies for small business owners and the self-employed.

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